Campbell & Company argues in its paper, Prospects for CTAs in a Rising Interest Rate Environment: A Refresh, that CTA performance is less dependent upon the interest rate climate than some may think.
The paper builds on the data presented by Campbell in a 2013 paper, which showed that traditional assets, such as US equities and Treasuries, have historically underperformed when interest rates are rising. In addition, it showed that CTA performance has exhibited a different pattern from these assets and has in fact not been regime-rate dependent.
With both the 10-year Treasury yield and interest rates on the rise in the US, the new paper seeks to update the quantitative elements of the previous study. To do this, it first looks at the performance of bonds and equities during periods of both rising and declining interest rates.
Using the Barclay’s Long-Term Treasury Index, which was launched in 1972, the paper showed that US Treasuries performed significantly better in declining rate periods, gaining an average +1.3% per month versus +0.5% per month in rising rate periods. Meanwhile, the data showed that equities is perhaps even more sensitive to the interest rate environment, as during this extended period the S&P 500 gained an average +1.7% per month in declining rate periods and just +0.4% per month in rising rate periods. By contrast, using data from the Barclay CTA Index going back to 1980, the paper shows that CTAs had a higher average monthly performance in rising rate periods, although it should be pointed out that the margin of higher performance was not statistically significant (as indicated in the overlapping error bars in Exhibit 4 from the paper).
This is the most simplistic method by which researchers at Campbell measured the sensitivity of CTA performance to the interest rate environment, but all the other methodologies they used all confirmed the data indicating that, from a statistical standpoint, the average returns of the CTA Index in declining and rising rate periods are indistinguishable.
Next the paper considers why this might be the case and concludes that diversification is one important explanation.
It points out that, although there are exceptions, most CTAs take a multidimensional approach to diversification, meaning that their portfolios usually include a range of strategies exploiting different alpha sources across different markets. Logic suggests that this approach to portfolio construction tends to offer a measure of protection from any single external risk factor.
“Market and sector diversification is customary, with many CTAs trading in 60 different markets or more. It is common for trading programs to include exposure to commodities, foreign exchange, fixed income and equity index futures, limiting the effect of any one sector on overall performance (though some specialist funds do target opportunities in one sector only, most commonly foreign exchange),” the paper states.
Historically, it’s been uncommon for all four of these sectors to be up or down for any one year, and thus while CTA strategies that trade across these sectors will always have some drag on performance from the ones that are underperforming, they are less susceptible to losses when one sector in particular underperforms. Of course, while it’s uncommon for all four sectors to be synchronised, it’s not unheard of – in the 20-year sample provided by the research, there are four instances where returns are positive in all sectors and one where all four were negative. Unsurprisingly, that one year, 2009, was not a vintage one for the CTA industry.
A final point on diversification made by Campbell in the paper is that while the majority of CTA programmes do still rely solely on trend-based strategies, some of these firms also use non-trend strategies, such as relative value, carry and mean reversion, which may provide profitable opportunities unrelated to the “trendiness” of markets.
The suggestion from this paper then is that while past data suggests that equity and bond returns are likely to be reduced as the US Federal Reserve continues raising interest rates, CTA performance is likely to be unaffected and thus could be a useful diversification tool in the portfolio during such an environment.